To decrease production costs, a company suggests replacing one of its manufacturing equipment with a newer,...

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Finance

To decrease production costs, a company suggests replacing oneof its manufacturing equipment with a newer, more efficient model.This four year project will result in reduced manufacturing costswhich, in turn, would allow a reduction in the price of itsfinished product. The current equipment can be sold today for$1,000,000 net. A brand-new equipment retails almost $3,250,000;however, it can be purchased for $3,000,000. Funding for thispurchase will include proceeds from the sale of the old equipment.In addition, accounts payable are expected to increase by$1,500,000 today, and fully reverse in year 4.
The new equipment will be in operation beginning in year two. Asthe old equipment will be offline in year 1, the company forecastslost revenues of $550,000 in year 1. The cost savings in years 2, 3and 4 are estimated at $600,000, $950,000, and $1,000,000,respectively. The company's cost of capital and tax-rate remainunchanged. What is the initial outlay for this project, theproject’s FCF for years 1 through 4, and the project’s NPV? Thecompany is concerned that the estimated cost of capital is toohigh. It adjusts it's Beta and computes a new cost of capital of5%. Using this, what is this project’s NPV?
Exhibits
MACRS 5 Schedule
Year 1: 20%
Year 2: 32%
Year 3: 19.2%
Year 4: 11.52%
Year 5: 11.52%
Cost of Capital
WACC =
Cost of Equity = Risk-Free Rate + ? (Equity Risk Premium)
After-Tax Cost of Debt = (1-Tax Rate) Pre-Tax Cost of Debt
Risk-Free Rate (10-Year U.S. Treasury) = 3%
The Equity Risk Premium = 4.5%
Tax Rate: 40%
Company's beta (?) = 1.2
Company's Market Value of Equity / Total Capital ratio =100%
Company's Market Value of Debt / Total Capital = 0%

Answer & Explanation Solved by verified expert

3.9 Ratings (721 Votes)

AnswerInitial outlay of the project Cost of new equipment Saleproceeds net of old equipment Increase in accounts payables 3000000 1000000 See Answer

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Transcribed Image Text

To decrease production costs, a company suggests replacing oneof its manufacturing equipment with a newer, more efficient model.This four year project will result in reduced manufacturing costswhich, in turn, would allow a reduction in the price of itsfinished product. The current equipment can be sold today for$1,000,000 net. A brand-new equipment retails almost $3,250,000;however, it can be purchased for $3,000,000. Funding for thispurchase will include proceeds from the sale of the old equipment.In addition, accounts payable are expected to increase by$1,500,000 today, and fully reverse in year 4.The new equipment will be in operation beginning in year two. Asthe old equipment will be offline in year 1, the company forecastslost revenues of $550,000 in year 1. The cost savings in years 2, 3and 4 are estimated at $600,000, $950,000, and $1,000,000,respectively. The company's cost of capital and tax-rate remainunchanged. What is the initial outlay for this project, theproject’s FCF for years 1 through 4, and the project’s NPV? Thecompany is concerned that the estimated cost of capital is toohigh. It adjusts it's Beta and computes a new cost of capital of5%. Using this, what is this project’s NPV?ExhibitsMACRS 5 ScheduleYear 1: 20%Year 2: 32%Year 3: 19.2%Year 4: 11.52%Year 5: 11.52%Cost of CapitalWACC =Cost of Equity = Risk-Free Rate + ? *(Equity Risk Premium)After-Tax Cost of Debt = (1-Tax Rate) * Pre-Tax Cost of DebtRisk-Free Rate (10-Year U.S. Treasury) = 3%The Equity Risk Premium = 4.5%Tax Rate: 40%Company's beta (?) = 1.2Company's Market Value of Equity / Total Capital ratio =100%Company's Market Value of Debt / Total Capital = 0%